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How banks can mitigate €120 billion in capital requirements and avoid an ROE haircut.

The Basel III regulatory framework was developed to enhance the stability of the financial system by raising requirements on regulatory capital and liquidity. Basel III increased thresholds for capital quality and quantity, raising Tier 1 capital requirements, introducing buffers and leverage-ratio requirements, and adding the Common Equity Tier 1 requirement (CET1) (see sidebar, “Basel III, TLAC, MREL, and more”).

Sidebar

Basel III, TLAC, MREL, and more

Basel III specifies capital target ratios of 7.0 percent for the core Tier 1 capital requirement, including a minimum of 4.5 percent of core Tier 1 capital and a required capital conservation buffer of 2.5 percent. A broader requirement for all Tier 1 capital is set at 8.5 percent; this includes the core Tier 1 minimum of 7.0 percent and an additional minimum for noncore Tier 1 capital of 1.5 percent. Additional hurdles are imposed by the Financial Stability Board’s minimum standard for total loss-absorbing capacity (TLAC) and the minimum requirement for own funds and eligible liabilities (MREL). TLAC is intended to elevate capital and leverage ratios for the 30 institutions determined by the Basel Committee on Banking Supervision to be global systemically important banks (G-SIBs). A G-20 agreement applies TLAC to all G-SIBs, and the rule is scheduled to become codified in the European Union on January 1, 2019. MREL is an EU bail-in standard with a minimum requirement of 8 percent of liabilities; introduced in 2014, MREL is being revised to align with TLAC. As the regulatory bar rises, furthermore, the Swiss regulator has recently set capital requirements even higher than EU standards.

Since Basel III was rolled out, the Basel Committee on Banking Supervision (BCBS) has been reviewing risk-measurement approaches internationally and among banks. One outcome of this review was the new standardized measurement approach (SMA) for operational risk, which was proposed in 2016. The committee also began a discussion on aggregated internal-rating model floors, concerned about the wide variation in the levels of risk-weighted assets (RWA) issuing from banks’ internal models. The committee finalized standards for minimum capital requirements for market risk—the fundamental review of the trading book (FRTB)—in January 2016.11.Basel Committee on Banking Supervision, Standards: Minimum capital requirements for market risk, Bank for International Settlements, January 2016, bis.org. The committee plans to make technical revisions to this framework in 2017–18, however, and the country-level implementation is still under discussion.

Together, the changes are part of a Basel III amendment now more commonly referred to as Basel IV. The Group of Central Bank Governors and Heads of Supervision (GHOS) indicated that it does not intend to increase the total regulatory capital requirements in the industry as a whole. It did, however, acknowledge that the impact “may well be significant” for some banks. Recent McKinsey research has gone further, suggesting that the impact of Basel IV will be significant throughout the banking industry.22.“Governors and heads of supervision announce progress in finalising post-crisis regulatory reforms,” Bank for International Settlements, September 11, 2016, bis.org; Stefan Ingves, “Reflections of a Basel Committee chairman,” keynote address, 19th International Conference of Banking Supervisors, November 30, 2016, bis.org; for more on McKinsey research on Basel IV, see Stefan Koch, Roland Schneider, Sebastian Schneider, and Gerhard Schröck, “Basel ‘IV’: What’s next for banks?,” April 2017.

Banks will also have to deal with further regulatory adjustments and discussions that are indirectly affecting capital requirements under Pillar 1 and Pillar 2. These new mandates include risk-data aggregation and IT (BCBS 239), the revised for interest-rate risk in the banking book (IRRBB), and the introduction of IFRS 9 accounting standards. This new regulatory environment will require banks to run large-scale implementation programs and to ensure they have adequate resources to cover substantial one-time costs and provisioning needs. Moreover, additional capital requirements imposed by supervisors, such as during the EU Supervisory Review and Evaluation Process (SREP), will increase capital thresholds and loss-absorbency requirements (total loss-absorbing capacity, or TLAC, and minimum requirement for own funds and eligible liabilities, or MREL). The resulting higher funding costs from new issuance of eligible loss-absorbing liabilities could vary significantly from country to country if the European Union is unable to harmonize implementation throughout Europe. Coupled with the revised risk-measurement approaches, the new rules will no doubt entail expenses that affect banks’ ability to build up organic capital.

According to our analysis, if banks do nothing to mitigate the cumulative impact, they will need about €120 billion in additional capital, while the banking sector’s return on equity will be reduced by 0.6 percentage points. That is, current CET1 ratios of European banks would drop by 29 percent, according to our calculations, declining from a ratio of 13.4 percent now to 9.5 percent. The severest effect comes from internal-ratings-based (IRB) output floors, which would decrease CET1 ratios on average by about 1.3 percentage points. Other significant drivers are the new standardized measurement approach for operational risk (0.8 percentage points) and Basel III phase-in (about 0.5 percentage points). The average return on equity for European banks would drop to 7.4 percent from 8.0 percent, assuming that banks take no mitigating actions and keep Basel III capital requirements fully phased.33.Stefan Koch, Roland Schneider, Sebastian Schneider, and Gerhard Schröck, “Basel ‘IV’: What’s next for banks?,” April 2017.

A holistic program for improved capital management

The totality of the Basel IV adjustments has not yet emerged, and therefore the expected impact of the new regulations cannot yet be fully articulated. Some recent developments can be reported. BCBS now seems close to settling some Basel IV details, including an aggregated IRB floor of total RWA. Based on the standardized approaches, the floor is 70 to 75 percent, a level supported by most EU countries, including Germany (France and the Netherlands are exceptions). Likewise, the US Federal Reserve has lately signaled a willingness to accept floor levels below 80 percent of RWA. For another aspect of Basel IV, expectations have changed. The transitional period in which the rules are phased in may run through 2027, rather than 2025 as had been forecast earlier, due to the effects on mortgage portfolios.

The impact of Basel IV will vary by location, bank type, and business model, and no set of mitigating actions could uniformly address every situation. Each bank will have to work out an appropriate capital-management strategy to mitigate the impact of Basel IV based on its own position. Optimal responses will vary by bank: for example, banks with focused business models could face a significant IRB output-floor requirement.44.As indicated, the standards for the output floor, which would replace the transitional capital floor adopted in Basel I, are still being discussed. The new rule is meant to mitigate model risk and measurement error resulting from internally modeled approaches and would limit the benefit in using internal models for estimating regulatory capital. In response, these banks will either have to adjust the composition of their business or move assets off the balance sheet. Banks with a more diversified portfolio will likely be able to respond with many smaller actions.

Each bank will likely need to adopt a package of changes big and small to improve capital management. Proposed strategic shifts in business models will have to be tested for sustainability in the new regulatory environment. Most banks can make beneficial business changes that do not require a new strategic focus, including the application of methods to increase capital efficiency and profitability. Also of primary importance will be more rigorous technical measures to measure risk-weighted assets more accurately and improve regulatory capital—for example, by reducing capital deductions (exhibit).

Exhibit

Strategic adjustments

The forthcoming requirements provide an opportunity for banks to rethink their portfolio of businesses, as well as individual business models. It will be important to review the business to identify activities that will become a drag on capital in a Basel IV environment. Given that internal models are restricted by applicable capital floors, banks whose business models are less sophisticated might suddenly become more competitive in terms of capital cost in certain product classes. The environmental change will increase competition and margin pressure for banks serving segments like specialized lending, where those using slotting or standardized models face significantly higher capital charges. Banks with less sophisticated models might suddenly become more competitive.

The top-down review of business activities should be based on a thorough understanding of how the new capital requirements affect each segment and product in both the current cycle and under stress scenarios. It will be crucially important to uncover the interdependencies and trade-offs among business segments and under different regulatory constraints.

First, banks will need to clarify the contributions made by each division to scarce regulatory resources (capital, funding, and liquidity) and their consumption. The complexity of this task should not be underestimated. Some of the metrics it requires are not consistently present and ready to use in typical IT systems. In addition to addressing the missing metrics, banks will need to focus on capital steering and allocation. This is because a number of diversification effects might arise once a bank is constrained by the IRB output floor. Banks could have to figure out how to allocate excess capital from operational-risk or market-risk standardized approaches to other business units or down to products, for example. This complicates capital steering for banks as they attempt to manage stressed and regulatory capital, capital buffers, and RWA-based and capital-requirements-based calculations. Only through a full understanding of the balance sheet at a group level will banks be able to quantify the total impact of division and product characteristics. Then banks can figure out how to adjust the balance sheet to optimize performance.55.Methods such as McKinsey’s Balance Sheet Optimizer can model the effects of particular responses to regulatory and business constraints to derive optimal strategies on balance-sheet size and composition as well as the potential to improve profitability.

Several leading banks have begun to use advanced modeling and optimization approaches to understand the evolving regulatory requirements. This process is typically interactive, in that strategic direction and business mix define the parameters of the modeling, and the model can help quantify feasibility and implications of a chosen strategic direction. Once the review is complete, the businesses that remain in the portfolio must adjust their business models to the new capital realities. Some businesses may require only small adjustments, while others will be fundamentally changed. Two areas for strategic focus are banks’ portfolio strategy and their legal-entity setup:

Updating the portfolio strategy. Banks should review their capital allocation to each client segment and region to ensure that capital is preferentially allocated to areas that generate higher returns (adjusting for risk, funding, and increased capital costs). Most banks have yet to institutionalize these capabilities. In trade approval, for example, value adjustments (xVA) are not often considered for changes in capital requirements, margin, or collateral requirements over the life cycle of a trade. Likewise, most banks need to adjust costs charged on the banking book for funding, liquidity, or capital to the new regulatory requirements. Client segments should be evaluated in growth and economics but also by capital requirements and capital efficiency—based on the current economic cycle and stress scenarios (to mitigate tail risk). With the evaluation for guidance, banks can then scale back business in segments and regions that do not add economic value—such as those that account for a big share of the bank’s risk-weighted assets without returning the cost of capital.

Reviewing the legal-entity setup. Many banks are already questioning the number of legal entities in their structure in light of resolvability requirements. Reducing the number of subsidiaries typically leads to substantial capital and funding savings; it can also achieve some cost savings, better transparency, and improved governance. At the same time, an optimized legal-entity structure improves resolvability and may help in reducing MREL and TLAC requirements. While many local supervisors want subsidiaries to exercise better control over risk exposures and balance sheets, supervisors are also in favor of simpler legal structures. In deciding the appropriate legal-entity setup, banks will take into account client impact and strategy, regulatory and legal factors, the financial impact, and the effects on operations, as well as governance and implementation requirements.

Business changes

Certain adjustments to the business can increase capital efficiency, sometimes significantly. Some changes might slightly reduce revenues but also release capital demand such that overall profitability and capital efficiency increase.

Tactical moves include small adjustments to the current product offering or to the requirements or deals, making them more capital efficient for the bank. Collateral requirements could be revised, for example, so that more collateral is required or collateral allocation is improved. To optimize product offerings, banks could phase out under-utilized lines, adjust contract clauses (for example, committed versus uncommitted, or maturity clauses), or pursue product swaps—especially for limits such as overdrafts and revolvers.

A review of client relationships can result in improved profitability. After FRTB, banks will see significant shifts in profitability in both the trading and banking book. To respond, begin by identifying the essential relationships—high-revenue clients, those with international significance, or those that are sources of funding. For low-performing clients, relationships can be modified or ended. To refine and prioritize this list, leading banks have created thresholds by segment and then analyzed each relationship. The prospects for making relationships more profitable will then emerge. Actions can then be proposed to relationship managers and criteria developed for renegotiating or ending the relationship. The approach requires that the bank set top-down targets for risk-weighted assets, capital efficiency, and cross-selling and work with relationship managers on client action plans. For trades, pricing and valuation will have to be revised to incorporate expected FRTB capital charges and value adjustments. By accounting for xVA, including for regulatory capital and marginal adjustments, banks would be able to capture the expected lifetime profitability of trades and understand whether to novate or break up trades. Where profitability targets are not met, an exit plan would take effect. The approach can then be expanded to the bank’s entire client portfolio.

Commercial actions can be undertaken to ensure that banks continue to meet client needs while also increasing capital efficiency. Areas for consideration are products, collateral and guarantees, repricing, and cross-selling. Banks can help themselves in achieving these changes by aligning front-office incentives with the new realities.

Product offerings can be adjusted, since over time some products by themselves become less attractive after capital costs. (Of course certain products will remain important for customer relationships.) For example, some institutions might need to stop offering certain mortgages and real-estate products that do not meet calculated tolerances to loan-to-value exposures or risk weights.

Banks should review their policies on financial collateral and guarantees. While IRB models accept nonfinancial and physical collateral for credit-risk mitigation, the standardized measurement approach does not. Banks using the IRB approach might want to prefer financial collateral or guarantees, eligible under both approaches, once the floor framework based on the applicable SMA risk weights is introduced. Guarantees of highly rated counterparts will become more important compared with physical collaterals due to deviation of economic and regulatory credit-risk mitigation.

Repricing and cost-management actions will be needed to support future profitability. Banks should assess the expected impact of the new regulatory requirements, especially in the product areas that are affected most, such as mortgages and commercial real-estate exposures. There will likely be opportunities to amend prices or reduce operating costs to make up for increased capital costs.

Banks should also look for opportunities to increase their cross-selling of fee-based products that do not create any additional capital charge.

Finally, banks will want to model the impact of tactical and strategic changes on profitability, and optimize the balance sheet accordingly.

Technical measures

Industry evidence indicates that all banks can improve the accuracy of their RWA calculations.66.Erik Lüders, Max Neukirchen, and Sebastian Schneider, “Hidden in plain sight: The hunt for banking capital,” January 2010; Bernhard Babel, Daniela Glus, Alexander Gräwert, Erik Lüders, Alfonso Natale, Björn Nilsson, and Sebastian Schneider, Capital management: Banking’s new imperative, McKinsey Working Papers on Risk, Number 38, November 2012. The quality of the data used can be insufficient for producing accurate results. Data can be incomplete and data usage can also be imperfect—as, for example, when data on collateral do not make their way from front-office systems to the RWA calculation engine. By improving RWA accuracy and processes, banks can often reduce their RWA under both the SMA and the IRB approaches. They can also avoid RWA increases, which otherwise could force extreme measures, such as exiting business lines. While many banks have already conducted an accuracy-improvement program for RWA, significant opportunity to reduce RWAs and improve economic profit remains. Even for banks with solid data accuracy in their IRB portfolios, further improvements are often possible. To make them, banks can use technical tools that do not require significant investments. Their impact, however, is often significant: an RWA reduction of €1 billion, for example, typically corresponds to an increase in economic profit of €10 million to €15 million.77.Assuming a capital ratio of 13 to 14 percent and a cost of equity of approximately 10 percent.

Many banks rightly focus on RWA accuracy, but considerable opportunity lies in reducing other capital needs, including capital deductions (such as minority interests, goodwill, intangibles, and nonconsolidated investments), capital buffers (for G-SIBs, under Pillar 2, and the countercyclical buffer), and trapped capital. For some banks, the Pillar 1 requirements constitute only half or less of their total capital requirements; the remainder is determined by these other demands. Depending on the situation, banks can take several actions to bolster capital. These include increasing RWA in entities with an excess of CET1, netting intangibles and goodwill deductions with linked deferred tax liabilities, and reviewing activation policies and amortization periods of expenses related to intangible assets.

Some banks have already begun to take a more holistic approach to improving capital. One global bank increased its capital ratio significantly by implementing a number of diverse measures. The bank correctly classified intangible assets, applied netting procedures in deferred tax assets and deferred tax liabilities to reflect goodwill and pension-fund deductions properly, and adjusted its legal-entity setup and asset-booking locations in line with minority-interest deductions. Another global bank significantly reduced its RWA by changing the regulatory treatment of one of its major participations. In close alignment with the national regulator, the bank managed to move from a look-through approach for calculating the RWA of the participation to the approach laid out in the most recent capital-requirements directive and regulation (CRD IV, CRR). This enabled the bank to consider the RWA and capital deductions of the participation itself. The overall CET1 ratio at the group level improved by about one percentage point, a result of a group-level RWA decrease of more than 10 percent—countered only by CET1 deductions of about 5 percent of overall CET1.

Until Basel IV rules are finalized

Each bank has its own capital-management plan. In our experience helping banks assess their needs in mitigating the capital impact of Basel IV, we have encountered varying levels of preparedness. Most banks have made good progress in improving RWA accuracy, eliminating data errors, and improving processes. Banks need now to focus on optimizing capital beyond RWA while sustaining their RWA improvements—by embedding the optimized balance sheet into strategic planning, selecting the right capital-steering metrics, and educating the front line on capital consumption and conservation.

As the impact of new regulations will vary by region, bank type, and business model, institutions should make specific impact assessments, identifying the portfolios and business segments that will be most affected. This requires banks to make a self-examination, testing for sensitivity to the new regulatory rules and accounting for new business economics in strategic considerations. Actions should be tailored accordingly, well analyzed in advance, and rigorously implemented. Some regulations will permit banks flexibility and adjustments in compliance (such as the gradual phase-in of the IRB capital floor, now forecast to extend from 2021 to 2027); nevertheless, banks should develop their mitigation plan without delay, at least to reassure forward-looking rating agencies and investors.

No-regrets moves

As final Basel IV rules are still pending, banks cannot fully develop their strategic response. Regardless of the final regulatory outcome, however, certain actions will improve banks’ capital position and risk-return profile in any scenario. These actions will also give banks a timely edge over the competition.

One such move would be to develop originate-to-distribute capabilities. This creates more balance-sheet flexibility through the distribution of assets to yield-searching buy-side firms. Banks could also make certain business changes, such as requiring more collateral, paring down under-utilized lines, adjusting contract clauses, and increasing profitability within underperforming customer segments. Banks should wait before implementing such commercial actions as adjusting product offerings or conducting repricing, however, as these will depend on the implied capital costs of finalized rules.

Correcting RWA accuracy and processes often reduces RWA under both the SMA and the IRB approach and will be beneficial whatever the regulatory outcome. At the same time, improving RWA calculations does not require high investments and is relatively easy to implement. Beyond RWA, other no-regrets moves involve the use of technical levers to improve capital deductions (minority interests, goodwill, intangibles, and nonconsolidated investments) and capital buffers (G-SIBs, Pillar 2, and countercyclical buffers). Finally, regardless of the results of their calculations, banks will need robust capital-steering mechanisms; they should begin considerations now on what adjustments are needed in these mechanisms to reflect stresses and regulatory capital (including diversification effects from IRB output floors). These moves can improve capitalization independent of the final Basel IV decisions.

The impact of Basel IV will, in our view, exceed most estimates, and banks will certainly need to raise more capital. Repercussions—and optimal responses—will vary by bank, according to location, positioning, and business model. The rules are not yet finalized, and the pace of implementation is yet being discussed. For now, banks should prepare for expected outcomes, define mitigating actions, and initiate no-regrets measures. This will give banks a running start on implementing a more efficient capital-management approach, so they can meet capital requirements without suffering a loss in profitability.

About the author(s)

Stefan Koch is an alumnus of McKinsey’s Cologne office. Roland Schneider is an expert in the Frankfurt office, where Gerhard Schröck is a partner.
Sebastian Schneider is a partner in the Munich office.
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